-11.70(-0.78%)

-0.67(-3.70%)

0.0000(-0.0000%)

This Natural Gas Stock Has a Weird Solution to Its Current Problem

Antero Resources
(NYSE: AR)
wants to start generating free cash flow so it can reward its investors through share repurchases and dividends. However, it's not yet producing sustainable free cash flow. That was a key message of CEO Paul Rady on the natural gas driller's
second-quarter conference call
.

He did, however, make it clear that the company has a plan to get to that point. Once that happens, it has the potential to generate a massive gusher of free cash, especially when measured against Antero's currently low stock price.

An onshore drilling rig with the sun setting in the background.

Image source: Getty Images.

Drilling its way out of the current dilemma

Rady started the call by discussing Antero's long-term strategy:

We remain focused on maximizing our ability to generate free cash flow on a sustained basis. As we look at our five-year development plan today, the best way to deliver maximum free cash flow on a sustainable basis is to grow production in the near term to fill our firm transportation commitments while we have attractive natural gas hedges in place. At current commodity strip prices, we forecast funding this growth primarily through cash flow from operations and the water earn out payment of $125 million expected in 2020. This allows us to preserve our strong balance sheet.

As Rady notes, instead of cutting capital spending and drilling fewer wells, Antero plans to keep its foot on the gas. That's because it signed take-or-pay contracts for capacity on pipelines like
Energy Transfer
's
(NYSE: ET)
recently completed Mariner East 2 and Rover pipeline system. As such, it's paying for that space whether it uses it or not. In the company's view, it's better to continue drilling so that it can fulfill its commitments than pay for unused space.

Antero plans to fund this growth with cash flow from operations, which it supports with hedging contracts that help lock in prices. In addition, it should receive a $125 million payment from its
midstream
arm
Antero Midstream
(NYSE: AM)
as a result of the growth of its water business since the sale in 2015. In addition to that cash payout, Antero Midstream's water system buildout will significantly reduce Antero Resources' production costs in the coming years.

A twist of pipelines with a bright sun shining through.

Image source: Getty Images.

A cash flow gusher awaits

Rady then said:

Once we grow into our firm transport and essentially eliminate net marketing expense in 2022, we're well positioned to be more flexible with our development plans and generate significant free cash flow. To provide some context, if we elect to just maintain year-end 2021 forecast production [of] approximately 4 Bcf [billion cubic feet] equivalent per day, the capital required to do so would be less than $900 million. This would result in our ability to generate free cash flow of over $400 million in 2022, even at today's commodity strip prices or over a 30% free cash flow yield. As opposed to downshifting to maintenance [capital expenditures] today and delivering one year of free cash flow with unfilled pipeline commitments remaining, our strategy positions us to deliver long-term sustained free cash flow generation.

As Antero's CEO points out, the company could slow its drilling pace next year and generate some free cash flow. However, it wouldn't produce as much cash as it could in the coming years because it would still be paying for unused pipeline space.

In the company's view, its production should grow enough by the end of 2021 to meet its capacity requirements. Once Antero hits that inflection point, it could tap the brakes on growth and reduce its drilling budget from 2020's expected range of $1.2 billion-$1.3 billion to around $900 million by 2022. Given the anticipated increase in production, the company would produce more than $400 million in free cash at current commodity prices. That's a lot of money for a company that has a market value of $1.2 billion. It's enough, for example, to buy back 30% of its outstanding stock at the current price.

The problem with this solution

While Antero Resources' strategy makes sense on paper, there's one big potential problem: gas prices. The company and its peers are currently producing more gas than the market can handle, which has pushed down prices. With Antero and most of its peers planning to keep their foot on the gas, supplies will continue growing. That could put even more pressure on pricing in the future if demand doesn't grow at a faster pace. While consumption should improve as more
LNG
export facilities and petrochemical plants come online, Antero is making a calculated bet that gas prices won't keep falling. That strategy could burn it if it's wrong, which has been the case over the past several years.

A better option, in my opinion, would be to slow down and generate free cash flow in the near term since the market doesn't need any more gas. It could then use that money to buy back its dirt cheap stock. The company could then reaccelerate its growth engine when market conditions improve, which could enable it to produce an even bigger gusher of free cash flow.